A Fiscal Cliff-Hanger

It’s not clear whether Federal Reserve chairman Bernanke meant scaling the sheer cliff face or a fall from a cliff top when referring to the looming fiscal crisis.

More likely his reference relates to the sudden combined and large overall reduction in government stimulus for the domestic US economy, and the risks this may entail to a faltering recovery.

After large-scale emergent government economic stimulus on the back of the GFC, the fiscal gear levers – public spending and taxation – are both simultaneously about to be moved in the opposing direction, as Congress is forced to take a good look at the federal budget position.

Even before the GFC the Bush administration introduced tax cuts for all, including the wealthiest 2% of the population (couples who earn above $250,000 and individuals who earn over $200,000).

Although President Obama has consistently campaigned against temporally extending the cuts for the wealthy top 2%, he compromised in 2010 in order to sure-up support for the temporary Payroll Tax cut and an extension to aid for the unemployed.

Add a touch of circumstance and fate to perhaps the Law of Unintended Consequences and the US finds itself at the cliff-face (or cliff-base depending on your point of view).

How big is the cliff?

The following sizeable policies are all due to be repealed and will have the simultaneous effect of increasing government receipts (revenue) and reducing government expenditure, thereby fuelling concern that too much deficit reduction too suddenly will force a weak economy into double-dip recession.

$65 billion total to be sequestered from most federal programs for the 2013 financial year as per the deal between Obama and Congress that ended their standoff over the raising of the nation’s debt limit

This 2011 Budget Control Act directed that both Defense and non-Defense discretionary spending be reduced (each by $55 billion a year for 10 years) by “sequestration” if Congress was unable to agree on other spending cuts of similar size: they agreed to reduce federal budget spending by $1 trillion over 10 years and to identify additional savings of $1.2 trillion by January 2013, failing which automatic cuts would kick in.

It doesn’t take a mathematical whizz to reconcile the numbers: the first and last policies alone save the government almost half a trillion dollars (4% of GDP) for the 2013 financial year. That is half a trillion dollars the economy cannot afford to lose now, according to most.

Among the fallout – if Congress fails to take any action before December 31 (2012) – is a significant increase in taxation on investment income, with tax rates on capital gains increasing from 15 per cent to 20 per cent, and tax rates on dividends rising to 39.6 per cent for top earners.

Adding a 3.8 per cent surtax on investment income for the wealthiest Americans – those with adjusted gross income (AGI) of more than $250,000 for joint filers and $200,000 for single filers – was part of the 2010 health reform law and takes effect in 2013. It means tax rates on capital gains would rise to 23.8 per cent, while those on dividends would increase to 43.4 per cent for the highest earners.

If Congress take no action by January 1, the US will be hit by a fiscal contraction worth $600bn in 2013, which could tip the economy into a new recession. This fiscal drag results from expiry of a series of Bush-era tax cuts as well as the entry into force of automatic cuts to defence and domestic spending programmes. At roughly the same time, US lawmakers will have to raise its borrowing limit, or face the risk that the country could default on its debt.

According to the New York Times, both Republicans and Democrats are inclined to remove the Sequester and the expanded alternative minimum tax and Medicare cuts for doctors alike, even to extend the Bush tax cuts for the 98% of taxpayers. That would go a long way in maintaining support for the nation’s fragile recovery. However, the difficulty then (and again) becomes the cumulating annual deficits.

For his part President Obama has said he wants a debt-limit increase regardless of the deal. With renewed post-election vigour, and buoyed by the Democrats gaining Congressional seats, the president has flagged a rise in tax rate, and it was not lost on the New York Times that a return to 39.6 % would raise about $1 trillion over 10 years.

Jackie Calmes’ column further suggests that a two-part deal may be on the cards, to extend the tax cuts and repeal those automatic spending cuts, but only on the understanding that this is to give Congress time to devise a complete overhaul of the tax code and entitlements programs (read Medicare and Medicaid) with the specific aim of reducing the budget deficit by $4 trillion over a decade.

What economists do not agree on is how much deficit is too much? Nevertheless, the nation will reach its debt ceiling in January 2013 — or March at the very latest. The entire scenario, with all possible options, is well summarised by a CBO infographic.